Top ranked SumZero investors recently predicted the crash of Valeant despite prominent hedge fund ownership. This time, award-winning analyst and long-time SumZero member Sid Choraria, senior analyst of APS Asset Management in Singapore has taken a contrarian view on hedge fund favorite JD.com (JD:US), one of China's largest retail websites. Mr. Choraria shared a 50 page thesis with the SumZero community, a condensed version of which is reproduced below. The full report should be read for tables/financial summary and with footnotes and disclosures.

APS was founded in 1995 by Wong Kok Hoi and manages approximately $3 billion in various Long only and Long/short funds focused solely on inefficiencies in Asian equities.

JD’s Business Model Cannot Rely on "GMV" Growth

In recent years, companies in the internet/e-commerce sector, especially consistently loss-making ones, have justified sky-high valuations by vanity metrics like Gross Merchandise Value (GMV). This has allowed them to raise money, as investors hope that someday GMV will turn into profits.

At APS, we believe that metrics like GMV, particularly for consistently loss-making companies, are no different from the metrics during the 2000 dot-com bubble – eye balls, page-views, clicks, etc. These metrics ignore traditional balance sheet and quality of cash flow analysis and rely on optimistic expectations that a new buyer will be willing and able to pay a higher price for higher GMV.

Our research suggests that one of the wildly overpriced stocks touting GMV metric is US listed Chinese e-commerce hedge fund darling, JD.com, valued at its peak at market cap of over $50bn boasting a shiny 2015 $71.4bn of GMV. Even despite its recent stock decline, JD’s market cap is over $30bn.

GMV is not unusual in the industry. However, JD was founded over 12 years ago in China, and is still loss-making. Therefore, we ask "is JD being run for high GMV, a meaningless metric which does not accrue to shareholders?" Notably, JD operating cash flow both before working capital and after is trifling relative to its GMV and its bigger competitors. Fitch highlights JD may be a high yield credit, while Moody’s/S&P gave JD the lowest investment grade rating at Baa3/BBB-.

GMV is an important metric to JD and its ability to keep raising money from capital markets for investments because it presents hope in the absence of profits. Hope about economies of scale. Hope about GMV turning into relevant profits in future to justify its $30bn high market cap.

Q4 2015, FY 2015 and Q1 2016, a set of weak results confirmed some of our key concerns in this paper. JD reported -$1.2 billion, -$1.5bn and -$141mm losses respectively. What was inexplicable during the earnings call was JD’s obsession with GMV and questions focused on GMV growth. Few questions were asked about deteriorating margins even when JD’s scale is now much larger. What happened to the economies of scale that JD promised, since GMV is now huge but losses grow? Economies of scale aren't working for few reasons: intense competition, order density dynamics, product mix and a business model with limited scale advantage. Even today JD derives nearly 75% of net revenues from 3C/home appliances – an intensely competitive space not limited from the Alibaba and its Suning partnership. What caps the irony is that the stock rose the day full year 2015 results was posted – losing $1bn does not matter because core GMV ex Paipai grew 84%. A sign of irrational exuberance? One may infer that some Western investors don't fully understand JD's model and GMV. Chasing GMV as an end in and of itself will not end well at current valuations.

$1B Written-Down Due to Incoherent Acquisition Binge

Looking at the balance sheet, JD’s “investment in equity investees” sits at RMB 8.86bn which was reduced from RMB 11.6bn, an impairment of RMB 2.8bn. Goodwill declined from RMB 2.6bn to RMB 29.1mm, an impairment of RMB 2.6bn. This indicates that JD is burning shareholder cash on businesses where it has limited track record and is significantly overpaying for investments.

To us at APS, what stands out during the earnings calls is that JD focuses on GMV, and questions focus on “how much can GMV grow going forward” and not about the poor capital allocation track record and impairment charge of Bitauto, Paipai, Tuniu, and other investments.

As an investor focused on realities rather than GMV, we see things differently. To have suffered a realized loss of RMB 9.37 billion ($1.5 billion) in 2015 and facing potential for more future impairments (as we lay out below) on equity investees in a short period of time suggest hurried decisions by management, lack of due diligence and questionable capital allocation.
What drove such capital allocation? Could it be the focus on GMV at just about any cost?

Let’s take a deeper dive into a few of JD’s investments [The full report has the relevant footnotes/disclosures from JD filings]:
Bitauto (NYSE: BITA): RMB2.9 bn impairment in 2015, further write-down potential. After Q1 2016 results , Bitauto stock down -13% and -9% in next two days post 1Q 2016 results. The JD CFO has been on board of Bitauto since 2010.
Tuniu: Stock is down 40% since May 2015 with potential for future write-downs.
Kingdee (268 HK): Estimated write-down of ~RMB 300mm under “Other Income”. Stock down ~45%.
Paipai swift goodwill impairment of RMB 2.75bn ($424mm) points to superficial due diligence
Yonghui Superstores (SHSE: 601933): Yonghui’s stock has dipped below RMB 9 purchase price even before cash even leaves JD’s balance sheet.
JD Finance is a loss-making business with limited disclosure. Valuation is questionable given intense competition from bigger competitors like Alibaba and Tencent and regulatory risk.

Management Team Has Limited Tenure for a 12 Year Old Company

Our diligence reading the filings on management aside from founder Richard Liu shows that the team had until recently a limited tenure of around 3 years . The CFO joined late Sept 2013 only months before the IPO and several key people in management have been with JD for only a few years. JD was founded over 12 years ago; where are the early members from the first 10 years?

According to media that are publicly available, JD’s founder, Richard Liu has been reported to lead a lavish lifestyle. The market has recently speculated about an expensive real estate purchase in Sydney. The $30 billion question is why is Mr. Liu making such a large purchase outside China when he has much to do in China with 81% of voting rights and his company which has not made a relevant profit?

While we respect and admire Richard Liu’s entrepreneurial spirit, we note that his past experience had been in electronics/home appliance. Track record matters. JD’s several new investments and business have recently burned shareholder funds. Therefore, is there a margin of safety at the current $30bn market cap and company had a peak $50bn market cap?

What is striking to us is the limited tenure of JD management team highlighted on JD’s 20-F Page 42 of the 2014 20-F states “majority of senior management joined us in the past 3 years”. For instance, JD’s CFO, Sidney Huang, joined late Sept 2013, just months before the IPO and the prior CFO, Shengqiang Chen was delegated to the nascent and loss-making Internet Finance business. We note Sidney Huang’s bio in the IPO prospectus and 20-F does not explicitly disclose the “two China internet companies” he worked between 2004-2006. According to public media articles on Forbes and Bloomberg highlight that Sidney Huang, JD’s current CFO had stints at a company called Longtop. If the media is right, why does the bio not mention this in JD.com’s IPO prospectus and 20-F?

We note other JD management also joined JD in the recent few years. For example, the CTO joined recently in April 2015, chief public affairs joined in Feb 2012 (2 years before IPO), Chief HR officer joined in Aug 2012 (2 years before IPO) and the head of JD Mall, i.e. the B2C group has slightly over 3 years at the time of IPO. The longest serving member outside of Liu is Shengqiang Chen, CEO of Internet finance but not proven himself in growing, managing and operating an internet finance business and he was replaced as CFO right before IPO.

Where and why have the early employees at JD left? JD should provide more clarity

There could be several reasons why management tenure is limited including i) no strong corporate culture, ii) controlling founder, iii) senior management and mid-management clashes and iv) many may not fully believe in the future of the company.

JD.com is a Hedge Fund Darling

According to APS founder Wong Kok Hoi, "Buying what others are buying may give you comfort of group strength and occasionally a good profit. Buying what others are selling indiscriminately may make you feel lousy as a loner but often produces a good profit."

JD.com has been a hot favourite among hedge funds and sell-side analysts. Its peak market cap had been over $50bn and even as of May 2016 despite the stock’s decline, JD has a huge market cap slightly over $30bn.

Financial market participants have liked JD’s GMV growth, which has risen 3.7x from RMB 125.5bn ($20.7bn) in Dec 2013 to RMB 462.5bn ($71.4bn) in Dec 2015. Q1 2016 GMV alone was RMB 129.3 ($20.3bn). Yet the company makes losses? JD in one quarter now has greater GMV than in the full year in 2013. Despite shining GMV, JD since IPO has reported bigger losses of RMB -5bn ($0.8bn) and RMB -9.4bn ($1.4bn) in 2014 and 2015 respectively. In Q1 2016, JD reported a loss of RMB -910mm ($141mm) compared to RMB -710mm in Q1 2015.

An article in Feb 2016 on investing website ValueWalk highlights that compared to former market darlings like Valeant, JD is potentially a crowded trade due to high hedge fund ownership. HedgeMind VIP lists JD.com in the “50 stocks matter most to hedge funds” and “50 stocks with the largest number of hedge fund investors”. Even hedge fund legend, Julian Roberston called JD “one of the great companies in China” in a CNBC interview.

While the presence of blue chip investors may provide some comfort, in investing one must do your own homework to ensure a margin of safety. Valeant highlighted that it was a “crowded market darling” owned by famous investors including Pershing Square, ValueAct, Paulson, Viking Global and even value investors like Sequoia’s Ruane, Cunniff & Goldfarb. Unfortunately, blindly following famous investors is not a fool-proof strategy. Mr. Buffett and Mr. Munger remain the exception in the industry.

On Valeant, legendary investor, Berkshire Vice Chairman, Charlie Munger said “I’m holding my nose” and Mr. Buffett called the business model an “enormously flawed business model”. We wonder what Mr. Munger and Mr. Buffett would say about valuing loss-making, consistently raising shareholder funds companies on metrics like GMV? Particularly, when a company has consistently made losses, despite 12 year history, raised billions of dollars since 2009 and taken $1bn in impairments/write-downs in short time burning real shareholder cash.
Given the track record thus far, JD’s business to APS appears not designed to make appropriate profits to have justified its peak market cap of $50bn and current $30bn. JD management so far seem to be happy to grow GMV as long as shareholders, bond holders, and banks are willing to give it money. Irrational exuberance? At over $30bn, is JD.com a crowded trade?

Sell-side analysts love JD – nearly 30 buy ratings with just one lonely sell rating. The stock has declined 40% since June 2015 peak – are expectations too high? If everyone loves the stock, can it be undervalued?

Non-GAAP Accounting Metrics Reliance

JD relies on non-GAAP metrics and disclosure is limited. We highlight 7 points below:
“Services and other” revenue has deferred revenue included and limited disclosure.
JD’s inventory has grown faster than 1P direct sales in 4 out of the last 6 years and in the last 2 years. Rarely a promising sign given huge $3bn of inventory as of Dec 2015.
JD relies on Non GAAP accounting metrics but several of the expenses should be viewed as real expenses given real cash was burned on investments.
JD consolidated operating cash before internet finance working capital is scant and GMV conversion to operating cash is limited even before internet finance business started.
Tencent strategic cooperation accounting assumptions at time of IPO arbitrary – given the future writedowns that ensued.
JD has a number of related party transactions that are large and merit closer attention. What is Staging Finance entity given it is responsible for RMB 1bn of related party transactions?

Insiders are Net Selling and Equity is Being Diluted

According to 2015 20-F, we note Fortune Rising, a vehicle controlled by founder, Richard Liu for JD employees has reduced JD stock over the last 12 months. In addition, large outside prominent shareholders like Hillhouse, Capital Today, DST from IPO have reduced stock as per SEC filings and included in the full report. At IPO, Richard Liu sold 13.9mm shares at IPO at $19 per ADS and no longer has a lock up on shares.

While insiders reduced position in JD, we note that the JD $1bn share repurchase announcement has not yet materialized...instead JD raised $2bn over last 4 months!
JD announced a $1bn share buyback however according to 2015 cash flow statement, there is no mention. Alibaba bought back billions in stock when the share price declined. We note that several other companies like Baidu, Netease and VIPShop conducted buybacks. Why did JD announce a $1bn share repurchase in 2015 and shortly after, raise $2bn for its internet finance and bond offering? Why would JD IPO at $19 and want to buy stock near $26, while insiders have been net sellers. Defies logic.

Based on the cash flow statement, the line “share repurchase” don’t exist. JD should provide greater disclosure on this share buyback announcement. So for those investors that got excited when JD.com announced a share buyback – it was not yet to be.
Instead, JD hurriedly raise $2bn in a short period after the share repurchase announcement, $1bn for its internet finance business and $1bn bond offering. See links below:
$1bn Internet finance: http://ir.jd.com/phoenix.zhtml?c=253315&p=irol-newsArticle&ID=2129840
$1bn bond offering: http://ir.jd.com/phoenix.zhtml?c=253315&p=irol-newsArticle&ID=2159782

How Long Does JD Have?

When a company continually comes to shareholders and bondholders to keep raising money – especially a consistently, loss making company, it merits attention. Regarding cash flow from financing, JD has a huge appetite for borrowing from capital markets, bondholders and shareholders. Since 2009, JD has raised nearly RMB 48bn ($7.5bn). The majority of the net increase in cash is coming from the “financing” line item.

In Q1 2016 (ending Mar 2016) alone, JD raised RMB 11.7 ($1.8bn). This is a combination of the $1bn in internet finance deal and the rest other types of financing. In April 2016, JD issued $1bn in US$ bond . The $1bn US$ bond financing is not yet reflected in the cash flow from financing. Adding this up to the RMB 11.7bn ($1.8bn), this would mean JD has raised $2.8bn in a short while.

History is replete with companies dancing while the music plays. In the past, it has been the dot-com bubble, when new economy metrics were invented, like eyeballs, page-views, visitors, number of friends. In the most recent bubble, CDOs dominated. A CEO of a bank had said “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”.

There may be several reasons that the capital market game is likely drawing to an end.
JD is now caught between a rock and a hard place – slowing GMV/revenue growth or relevant profitability to justify valuation?: As evident in Q1 2016 results, JD.com can no longer dismiss profitability for GMV/revenue growth. Previously, the company’s model was to grow GMV but in Q1 2016, even marketplace GMV has slowed down significantly and contribution declined – one of the comments made was due to “anti-brushing”. So, as JD’s GMV growth slows – JD will be forced by investors to show meaningful profits in the next 12-24 months – meaningful enough to justify its market cap. This will have to come at the expense of GMV and revenue growth. However, some investors had valued the stock once at peak market cap of $50bn due to its GMV and revenue growth.

As GMV slows, does JD have relevant profitability to justify market cap valuation?: The premise that JD’s business model will produce profits with economies of scale remains to be seen and currently we have more questions than answers. Its core electronics/household appliances businesses (74.1% of net revenues) is unlikely to make relevant money even if the scale doubles because competition is intense and more efficient retailers are barely making a profit. What many do not realize is that their core 1P business (93% of net revenues), still very significant, can not make a relevant profit because of market-wide razor thin margins and intense competition from the likes of Alibaba and Suning. Services and others revenue declined from 8.6% in 4Q 2015 to 7.4% in 1Q 2016 and even this 7.4% is likely lower as accounting ways like deferred revenue, interest income from internet finance included must be adjusted. Intense competition from players like Alibaba means JD’s 3P business will not make sufficient money to underwrite the losses in other businesses. On costs, fulfillment and marketing costs as a % of revenue will rise as JD gets into i) lower tier cities; ii) new businesses such as O2O and internet finance are extremely competitive and not generating sufficient GMV for the costs involved. Growing the GMV of these businesses do not make sense as more cash will have to be burnt. At the same time, it is worth noting that China’s big three, Baidu, Alibaba, Tencent (BAT) – make huge profits in their core businesses and can afford to burn cash through internal cash flow, while JD has to raise money. Investors have valued companies like JD on high GMV in the past – but if JD cannot make $1 of profits from RMB 446bn of GMV, when will you do so? If the company still can’t make a relevant profit this year investors will start questioning the scale argument. The more forgiving investors will give it at most next year to see a ‘reported consolidated GAAP profit’. Then the next question, “Why so little profits?”

According to Fitch, JD has a high yield credit profile – balance sheet is weak: JD’s balance sheet is not as strong as investors might believe and valuation at $30bn suggests. Even today, equity investees (which could have further impairments as highlighted in Section 2) are more than fixed tangible assets. It is therefore not a surprise that the company raised $2bn in the last few months to finance unprofitable and cash burning businesses. Fitch has commented that JD may have a high yield credit profile and JD was rated the lowest investment grade rating by Moody’s and S&P.

Five Scenarios will cause investors and analysts to question JD’s business model

1. When GMV slows down to 30-40% p.a. and JD is still unable to make meaningful profits.
2. When markets stop lending JD money, JD’s cash burn will mean GMV won’t pay back its obliging shareholders and bondholders.
3. Intense competition led by Alibaba, in collaboration with Suning and a long list of other competitors in China, both online and offline retailers with longer track record
4. Non-GAAP accounting metrics are analyzed and risk disclosures in 20-F scrutinized
5. Insiders continue to reduce position in JD.com and investors begin to ask why?

JD is not Comparable to Amazon.

1. JD’s non-GAAP gross margins do not count the real cost of business compared to Amazon
2. JD uses weighted average inventory accounting vs FIFO for AMZN. AMZN switched in 2002
3. JD’s technology spend pales in comparison to Amazon. Amazon has significant AWS investments, which JD does not have the luxury of.
4. JD’s net tangible balance sheet is insignificant in comparison to Amazon’s balance sheet
5. Amazon generates significant operating cash flow relative to revenue while JD’s operating cash conversion both before and after working capital is scant.
6. Amazon does not discuss GMV. Focus is on the long term and return on invested capital
7. Amazon’s management team has served at the company for a long tenure. JD was founded in 2004 – where have the founding staff gone since majority of team joined within 3 years!
8. Amazon has a significant international presence including countries like India – JD’s business is almost entirely China where macro is slowing and JD faces brutal competition from bigger players like Alibaba.

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